The myth of deflation in Japan

29.06.15 Publication:

What do you think is the biggest danger facing Abenomics? My answer is that the biggest danger is that Abenomics’ monetary arrow might succeed too well.

By that I mean that the risk is that the monetary arrow could end up creating too much inflation. And if that happens there would finally be the disaster some people have been predicting (wrongly so far) for decades, namely a collapse in the government bond market.

For nearly 20 years, one of the main words that economists have used in connection with Japan has been deflation. This has gone on for so long that it has become assumed, almost without thinking, that the key economic task for Japan is to end deflation and that replacing it with inflation would be a good thing. So on that viewpoint, the massive monetary expansion being undertaken by Governor Kuroda at the Bank of Japan looks crucial, as a way to cure deflation.

Yet all of this obsession with deflation is based on a misconception. That misconception is that deflation is a, or the, cause of Japan’s economic problems. So to end deflation must be to solve those problems.

The truth, however, is that deflation is not the cause of Japan’s economic problems. It is an outcome of Japan’s economic problems, a symptom of them. Doctors do not cure diseases by addressing symptoms, but by confronting the underlying cause of the disease.

The underlying disease is a shortage of demand in the economy, whether from households, companies or the government. When incomes are falling or stagnant, consumption is weak and companies are not inclined to increase their investments, so demand remains weak. The result is weak or no growth, and falling prices.

Deflation could in theory be a direct cause of such weakness. This would happen if people and companies had money to spend, but kept on delaying doing so in the expectation that goods and services were going to get cheaper in the future.

But this has not been what has been happening. Consumption has not been deferred. How do we know? Because the household savings rate has fallen to zero, or even is sometimes negative. Households are not saving their money in the hope of spending it later. They are not saving money at all any more, because they cannot afford to. Their incomes are too low to allow savings.

I never thought I would see a day when Americans were bigger savers than Japanese. But the American household savings rate is now 5-6% of real disposable income, while the Japanese rate is zero. In America, people really have been limiting their spending in order to save up money; that seems to be why the fall in oil prices has not brought about a consumption boost in America.

In Japan, the problem is falling incomes, not falling prices. And any success that Governor Kuroda achieves in creating inflation will just make those incomes buy fewer goods, unless wage rates really begin to rise faster than price inflation.

Governor Kuroda surely understands this. He knows that deflation is not the real enemy. The real enemy is weak demand and falling incomes. The real aim of his monetary expansion has been to try to give businesses an incentive and the confidence to increase their investment and to raise wages.

So far, however, the main impact of the monetary arrow has been on the yen exchange rate rather than wages or investment: in real, inflation-adjusted terms, the yen is now at its lowest level since the late 1990s. Alas, this only helps the sector of the economy that depends on exports, which is less than one-fifth of GDP. The other four-fifths see their import prices rising thanks to a weaker yen.

Admittedly, the monetary arrow has helped one other institution: the Tokyo stockmarket. At least, vast monetary easing is the best way to explain why Japanese equities have kept on rising so strongly, despite rather disappointing economic growth figures.

It is possible that very soon there will begin a virtuous cycle of rising wages and rising household demand, which in turn will boost corporate profits and investment, which will eventually justify high equity valuations.

The big worry, though, is if this doesn’t happen. Wages might rise, but the money might be saved rather then spent, and the virtuous cycle won’t happen. Instead, there will be price inflation.

At that point Governor Kuroda will have succeeded, but too well. The victim of such success would be the Japanese economy.